Market capitalization is a term used to describe the size of a company based on the total value of the company’s shares. Market capitalization is an important data point for making informed investment decisions, managing return expectations, and building a balanced portfolio.
Knowing the total value of stocks can help investors distinguish between risky and conservative investments, or help them diversify based on their specific goals. For example, large companies may be more stable and have less room to grow their returns, but may be the right choice for a portfolio with a short time horizon or for an investor with a low risk tolerance. Market capitalization, or market capitalization, provides some of the information to make these decisions.
How market capitalization is calculated
A company’s market capitalization can be found by multiplying its current stock price by the total number of shares outstanding. Outstanding shares are shares issued and sold to shareholders, including shares held by insiders and institutional investors. The calculation does not include treasury shares. These are shares of the company that she has purchased.
For example, if company A has 20 million shares outstanding and a share price of $500, its market capitalization is as follows:
$500 X 20,000,000 = Market cap of $10,000,000,000
Again, that’s the price of one share multiplied by the total number of shares outstanding.
How a company’s market capitalization is classified
So, assuming Company A has a market cap of $10 billion – what does that actually mean? Companies are typically divided into three main categories based on their size:
- Large hood: Companies with a market capitalization of $15 billion or more
- Mid-hood: Companies with a market capitalization between $3 billion and $15 billion
- Small cap: Companies with a market capitalization between $300 million and $3 billion
In the example above, Company A with a market capitalization of $10 billion could be considered a mid-cap.
Sometimes investors classify stocks that are much larger than large-caps as mega-caps, while stocks that are smaller than small-caps are sometimes called micro-caps or even nano-caps.
What market capitalization means
The market capitalization of a company often says something about the quality of the underlying activities of the share and the way in which the share trades. Below are some of the biggest differences between small-caps and large-caps.
Large caps are typically known as stable companies with robust balance sheets. These companies tend to exhibit less volatility during market downturns than their SME counterparts.
Companies with large market capitalizations are among the largest companies in the business world. Companies such as Apple, Microsoft, Alphabet, Amazon and Berkshire Hathaway occupy the large-cap market. Large-cap companies often have a reputation for producing quality goods, demonstrating steady growth and are often dominant players within established industries.
“During an economic downturn, large-cap companies have historically outperformed their small- and mid-cap counterparts, largely because they represent more established companies with stronger balance sheets,” said Mark Andraos, partner at Regency Wealth Management in New York.
Smaller companies, on the other hand, can be a mixed bag. While smaller companies may have more room for growth than large-cap companies, their less established positions within their industries and generally weaker balance sheets mean that investing in these companies carries more risk, but also greater potential returns if they succeed.
That said, there is a place for mid- and small-caps in certain portfolios. “In any industry there can be a handful of big players. It’s the smaller players where you can sometimes find value,” said Holmes Osborne, managing director of Osborne Global Investors in Missouri.
Market capitalization is a fundamental piece of information needed to make investment decisions, providing an overall picture of a company’s value. However, market capitalization can fluctuate widely from day to day, especially for smaller companies, as stocks move back and forth.
Looking at a company based solely on its market capitalization will not provide you with information about the company’s debt load and the potential risks associated with it.
How market capitalization affects investment strategy
Market capitalization can affect how you build an investment portfolio. Experts generally recommend diversification, which means owning a combination of small, medium and large companies.
“To be fully diversified, one generally has to be diversified across market cap and across value/growth,” says Robert Johnson, CEO and chairman of index development and licensing firm Economic Index Associates in New York.
For example, if your goal is big returns, you can focus on small caps but also invest in some large caps to reduce volatility. So you can combine the best small-cap ETFs with a selection of the best large-cap ETFs.
“It’s much more likely that someone can hit a home run by investing in small-cap stocks, but it’s also more likely that a strikeout will occur,” Johnson says.
If your goal leans more toward stability, you can focus on large caps, but you can also include smaller companies with growth potential to add some extra strength to the portfolio.
Or you can even split the difference by buying mid-cap stocks or the best mid-cap ETFs, which enjoy higher growth than large-cap stocks, along with higher stability than small-caps.
But be careful when adding individual stocks to an index fund portfolio, as you may be adding additional exposure to companies you already own.
“Most index funds today are weighted by market capitalization. Nearly 20 percent of the S&P 500 is in technology companies like Apple, Microsoft, Google, Amazon and Tesla, and combining a typical market-weighted approach to investing could over-concentrate a portfolio in technology,” said Doug Amis, CEO of Cardinal. Retirement Planning in the Chapel Hill, North Carolina Area.
Then, by using your time horizon and risk tolerance as benchmarks, you can build a diversified selection of investments.
In short
Understanding market capitalization is important when it comes to selecting your investments as it can help assess the overall opportunity of an investment. However, it does not provide a well-rounded representation of a company’s expected returns, which is why investors should evaluate companies carefully when constructing their portfolios.
